The "Down Day" Technique for Writing Covered Calls
by John Brasher, CallWriter Publisher

There are trading strategies that rely on entering trades when the the stock or other security is having a down day. Can entering a trade on a stock's down day be advantageous in writing covered calls? Like so many other trading questions, the answer is - it depends. This newsletter issue looks at some concrete examples.

Stocks normally oscillate up and down even when there is no news, or no significant news that should be moving the stock. Whether the stock is in an uptrend, downtrend or range, from day to day the stock can trade up or down as much as a couple of percent without raising an eyebrow. Some stocks oscillate more than others - are more volatile, historically. But all stocks move up and down. I was recently asked if one should seek to enter a covered call trade when the stock is down, meaning that it is down from both yesterday's close and today's open. The theory is to find a good trade setup (a good potential covered call trade) and wait to enter it until the stock is having a down day. For purposes of this article, let's refer to the practice as "down day" writing.

In and of itself, "down day" entry will not necessarily make a large difference in your covered call writing. The rationale for it is that you pay a little less for the stock, and that is certainly true. On the other hand, you receive less for an in-the-money (ITM) call, too, because ITM calls drop dollar-for-dollar with the stock or very close to it. The main advantage to the "down day" technique in covered calls is to enter trades where an out-of-the-money (OTM) call is to be sold, because OTM calls do not drop dollar-for-dollar with the stock.

Some Concrete Examples

It always helps me to look at concrete examples to see how a strategy or technique works in black and white. So let's look at the effect of writing a stock on a down day, considering both an ITM and OTM call.

Example:  Suppose the stock was at $20 yesterday, and the 20 Call was selling for $1.00, the 17.50 Call for $3.10 (0.60 of time value). This morning the stock opens at $19.75 and trades down to $19.30, at which point the 20 Call is selling for $0.75 (only dropped 0.25), but the 17.50 Call is selling for $2.40 ( 0.60.still is time value). The pullback in the stock made the stock cheaper to buy, but also affected the potential return, as shown below:

Example 1 In-the-Money (ITM) Call
Stock at $20			Stock Falls to $19.30
Buy Stock	- $ 20.00		Buy Stock	- $ 19.30
Sell 17.50 Call	+$ 3.10		Sell 17.50 Call	+$ 2.40
Net Debit (breakeven)	- $16.90		Net Debit (breakeven)	- $16.90
Time Value in premium	$  0.60		Time Value in premium	$  0.60
Return Called	3.0%		Return Called	3.1%

In the case of Example 1 above, the premium fell from $3.10 to $2.40, but the potential return did not change, because the time value portion of the premium remained at $0.60. Thus the trade's net debit (the breakeven point) did not change, and there was no real advantage whatever in waiting for a down day. The trade's return percentage increased from 3% to 3.1%, but it is the same $0.60 of time value. On this trade, entering on a down day made no difference.

However, if the time value had fallen on this trade when the stock dropped, then entering on the down day would likely have been a disadvantage, as the next example illustrates.

Example 2 In-the-Money (ITM) Call
Stock at $20			Stock Falls to $19.30
Buy Stock	- $ 20.00		Buy Stock	- $ 19.30
Sell 17.50 Call	+$ 3.10		Sell 17.50 Call	+$ 2.25
Net Debit (breakeven)	- $16.90		Net Debit (breakeven)	- $17.05
Time Value in premium	$  0.60		Time Value in premium	$  0.45
Return Called	3.0%		Return Called	2.3%

In Example 2 above we are assuming that when the stock price dropped to $19.30 that the premium on the 17.50 Call dropped to $2.25 instead of $2.40, meaning that the time value dropped from 0.60 to 0.45. Since all the return on ITM calls is in the time value part of the premium, the potential return dropped by almost a fourth, from 3% to 2.3%. The trade's net debit (breakeven point) was also raised from $16.90 to $17.05. In this example, entering on a down day clearly worked a disadvantage.

Now let's consider an ATM call which becomes OTM when the stock drops:

Example 3 At-the-Money (ATM) Call
Stock at $20			Stock Falls to $19.30
Buy Stock	- $ 20.00		Buy Stock	- $ 19.30
Sell 20 Call	+$ 1.00		Sell 20 Call	+$ 0.75
Net Debit (breakeven)	- $19.00		Net Debit (breakeven)	- $16.90
Return Not Called (flat)	5.0%		Return Not Called (flat)	3.89%
Return If Called	5.0%		Return If Called	7.51%

In the case of Example 3 above, the premium fell from $1.00 to $0.75, a $0.25 drop in time value, since ATM and OTM premiums are all time value. If the stock remains at $19.30 at expiration and is not called out, the uncalled return from writing the 20 Call would have dropped from 5% to 3.89% compared to writing the stock when it was $20, and the down day technique would not have been productive. If on the other hand the stock price recovers on its normal oscillation and the writer is assigned, the writer would receive $20, so the writer would keep the $0.75 premium and would receive the $0.70 difference between the $19.30 paid for the stock and the $20 strike price, which would boost the return to 7.51% [(0.75 + 0.70) ÷ 19.30]. Suppose the stock went up before expiration, but not all the way to $20 - say, $19.60? The writer would sell the stock for $19.60 and keep the difference between the 19.30 paid and the 19.60, adding another $0.30 of return to the $0.70 premium received.

How Well Does It Work?

Clearly, there can be advantages to entering a covered call trade when the stock is having a down day. The technique usually works best on calls that are OTM, and on ATM calls when the drop in stock price takes the call OTM. As illustrated in Examples 1 and 2, it does not often present any trading advantage on ITM calls. Price oscillation is a fact of life in trading, in every market, and the essence of down day entry is to pick up a slight advantage on the trade. It is a bit scary, and definitely counter-intuitive, to enter a trade when the stock is down, but if you have done your analysis and concluded the stock is a good covered call candidate, you should be comfortable with it despite the pull back. If on the other hand, writing the stock when down produces psychological discomfort, don't use the technique - the aim of trading is not to make a few extra pennies through clenched teeth, but to make money and have fun doing it.

How important is the down-day entry strategy? In any one trade, it is unlikely to be very significant. Even if the down day technique produces only a small advantage - such as half a percent more return, or the same return for $200 less of a net debit, it is still worth doing. And over the course of a year, these incremental advantages add up, perhaps 6% - 10% extra return over a full year, more if you trade more actively. It requires discipline and the willingness to wait, once you've found a satisfactory trade, for the down day.

Sometimes a stock on our Real Time Lists™ is already having a down day, and sometimes it will be necessary to wait - and you won't always get a down day before the event driving call premium occurs. I would not let the application of this technique keep me out of good trades, though.

Down Day or Down Stock?

Before using the "down day" strategy, be sure first of all to check the stock's news and make sure there is not a reason for the down day. Check the headlines, therefore. Then make sure there have not been any analyst downgrades. While I don't like analysts any more than you, a downgrade from a major firm like Salomon can knock the stock back, so in that event make sure the stock has regained its "sea legs" before trade entry and that the down day has not become the new trading level - consider watching the stock a day or two in case the pullback continues. The bigger the down day, the more reason for concern. In the examples above, I posited a $20 stock that dropped from $20 to $19.30, which is well within the oscillation range for most stocks. [Of course, if the stock has been trading at $19, then $19.30 is not a down day; the $20 day was a small spike.]

Be sure to also check the technicals thoroughly to make sure the "down day" is not a new downtrend. In other words, if yesterday and the day before were also down days, rethink the trade!

Watch the stock's index. It is a good practice when using the down day technique that its index be down, as well. The reason is that if the index is up that day and the stock is down, the stock is showing some weakness against its market that day.

For a covered call trade that will be ATM or close to ATM, I like to see the stock in an uptrend on a 60-minute chart, even if that day is down. If the daily and 60-minute charts are not in agreement, the stock has to be showing strength on the 60-minute chart and the daily chart should not be showing me anything bad, even if it is not as strong as the shorter-period chart. If the write will be OTM, however, I want to see real strength on both the daily and 60-minute charts. I am speaking here of the stock's trend, not whether it is flat, up or down on a particular day.

Question:   Do you tend toward in-the-money (ITM) covered call writes during sideways or downtrending markets?

Answer:  It varies. In downtrending markets, the answer is generally yes. This is why we developed the CallWriter Deep in the Money lists. It is a fallacy that one cannot write covered calls in a dropping market or on a dropping stock. That old canard gets repeated endlessly, but persons making the statement haven't had the same experiences as me and perhaps have not had access to tools such as our the Deep in the Money lists. What is true is that you cannot safely write covered calls when the market in a steep decline or collapsing, but when the market is in a fairly gentle to moderate downtrend, many stocks can be written with a fair degree of comfort -- particularly larger, more stable household-name stocks.

Keep in mind also that even in downtrending markets, there are stocks that outperform the market; that perhaps are even in a nice uptrend. This is why I have been able to write short-term, at-the-money (ATM) calls on good stocks when the market was downtrending - - because the stock was in an uptrend and showing strength on both daily and 60-minute charts. Sometimes even out-of-the-money (OTM) calls can be written on these counter-trending stocks, but your technical chops had better be pretty good if you choose to do it. Keep in mind that if OTM calls are not assigned, the stock may at any time weaken due to the market's gravitational pull and require management or repair.

In sideways (ranging or channeling) markets, the dynamic is different. When the market is in an up leg of the range, ITM and ATM calls work just fine, and there is no reason one cannot write OTM calls. If the market legs during the range are of short duration, as was the case in much of 2004, it may be too difficult to try to catch the up leg. In that case, my philosophy is to either write ATM on a stock that is showing significantly more strength than its index, or simply write ITM. Again, some stocks will seriously outperform a ranging market. When the market is in a down leg of a ranging market, it makes more sense to write ITM, if only because you are more likely to be called out and because the trades are less likely to require management techniques, such as rolling the calls down or put you in a repair situation.

If you truly are concerned about the market, definitely don't write OTM. It is better to write ITM when in that frame of mind, because it offers the most downside protection and you are far more likely to be called out. You'll sleep better, and trading is not supposed to be stressful from the point of trade entry! Just don't let writing ITM lull you into a false sense of security; do the proper analysis and planning, because ITM writes do not suspend the rules of disciplined trading and are no license for carelessness.

Good luck and good trading!